Venture capital (VC) funds are getting bigger, and their limited partners (LPs) are demanding more protections. That has pushed VC terms closer to those of buyout funds
In the past few years investors have earned huge returns by investing in early-stage tech companies – some of which have become unicorns, or privately-held companies worth more than $1 billion. And it’s clear that there are still opportunities to disrupt traditional services, especially given widespread mobile internet access and increased willingness to participate in the so-called sharing economy.
Previously VC funds focussed on seed capital or early-stage investments which were smaller. They had fewer resources than private equity (PE) or buyout funds, and therefore included fewer investor protections for LPs.
However as VC funds grow, LPs are less willing to concede on these points.
“The trend is that larger institutions such as sovereign wealth funds are coming into VC funds, and their involvement has changed the dynamic,” said Lorna Chen, partner at Shearman & Sterling.
One reason for this is that VC funds have gotten bigger. Traditionally they were too small for large institutional investors.
“Now that there are $200 to $300 million funds, then the ticket size starts making sense,” said Chen. “That’s why we’re seeing them deploy funds to VC – to diversify or rebalance and make a bet on the tech sector.”
KEY TAKEAWAYS
Venture capital and buyout funds’ partnership terms are converging as more large investors begin participating in VC fundraisings;
Management fees for VC funds are aligning with those for PE funds, but carry terms remain different;
An increase in the number of large investors in the VC space may also mean longer side letters.
Management fees
The way a VC typically works is that the management fee is charged on committed capital for the whole life of the fund, explained Gavin Anderson, counsel at Debevoise & Plimpton. In PE funds, the fee is typically charged on committed capital during the investment period; after the investment period ends, it is charged on committed capital.
He noted that a number of VC funds – although certainly not all – have moved towards the PE model, adding the concept of the investment period with a fee base shift from commitments to committed capital thereafter.
Carry
There is less convergence in terms of carried interest.
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Larger institutions such as sovereign wealth funds are coming into VC funds, and their involvement has changed the dynamic |
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“Targetcos tend to be on the early side, and the manager is taking on more risk, so what we see – and this has not changed – is a more aggressive waterfall on the GP side,” said Chen.
She’s seen no preferred returns as well as higher carry percentages. “Carry is usually 20% in the PE world, but it can be 25% to even 30% in the VC world plus no preferred return,” she added. “That’s a pretty different waterfall composition.”
Deal-by-deal distribution waterfalls are still very much the norm for VC, added Anderson.
However, while PE and VC funds aren’t quite converging, they are moving in the same direction. Investors want more protection against managers taking a lot of carry on early deals without having returned sufficient capital.
“VC fund partnership agreements are often a bit thinner than PE fund documents – around 20 to 30 pages lighter in some cases,” Anderson added.
Some of the provisions that get left out are around investor protection, such as the right to kick out the GP and the right to dissolve funds, he said. “Some LPs are now pushing for these to be included in the documents, which are now longer and a bit more LP protective. It’s the same trend that we’ve seen in the PE world.”
More bespoke protections
Chen said that once you start to see securities and banking firms, and sovereign wealth funds, they have internal policies and must-have provisions otherwise they can’t invest. “We’re also seeing bigger side letters,” she added.
And the expansion of side letters – which matches trends in PE – is likely to continue. This is because certain LPs have requirements that aren’t included in the VC fund agreement because they aren’t applicable to all investors.
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